National Income and Price Determination — Hard Practice Quiz
A Macroeconomics cheat sheet for National Income and Price Determination — every key formula with its symbols defined — plus a hard-level practice quiz to test recall.
Formulas & key concepts
The fraction of an additional dollar of disposable income that a household spends on consumption.
The fraction of an additional dollar of disposable income that a household saves; MPC and MPS always sum to 1.
An initial rise or fall in spending that is not itself caused by a change in real GDP, and which sets off the multiplier process.
The ratio of the total change in real GDP to the initial autonomous change in spending that caused it.
The size of the multiplier depends on the MPC: a larger MPC means a larger multiplier and a bigger change in real GDP for any given change in spending.
An equation linking a household's consumer spending to its current disposable income.
The amount a household would spend even if its disposable income were zero.
The relationship between total consumer spending and total disposable income for the whole economy.
The investment spending that firms intend to undertake during a given period.
The value of the change in firms' inventories over a period, which counts as part of investment.
Unintended swings in inventories that occur when actual sales differ from what firms expected.
Planned investment spending plus unplanned inventory investment.
Shows the total quantity of goods and services demanded across the economy at each aggregate price level; it slopes downward.
A higher aggregate price level reduces the purchasing power of money holdings, lowering consumer spending, which helps make the AD curve slope down.
A higher aggregate price level raises money demand and interest rates, reducing investment and consumption, which also makes the AD curve slope down.
The AD curve shifts with changes in expectations, wealth, the existing stock of physical capital, and government fiscal and monetary policy.
The government's use of taxes, transfers, and purchases of goods and services to shift the aggregate demand curve.
The central bank's use of changes in the money supply and interest rates to shift aggregate demand.
Shows the total quantity of final output producers are willing to supply at each aggregate price level.
The dollar amount of a worker's wage, unadjusted for inflation.
Nominal wages that adjust slowly to economic conditions because of contracts and social norms.
Upward sloping: because wages and some prices are sticky, a higher price level temporarily raises output.
Vertical at potential output: once all prices, including wages, are flexible, output does not depend on the price level.
The level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible.
The framework that combines aggregate demand and aggregate supply to determine the economy's price level and output.
The point where the aggregate demand curve crosses the short-run aggregate supply curve, setting the short-run price level and output.
An event that shifts the aggregate demand curve, moving the price level and aggregate output in the same direction.
An event that shifts the short-run aggregate supply curve, moving the price level and aggregate output in opposite directions.
The combination of falling output and rising prices, produced by a negative supply shock, as in the 1970s oil crises.
The point where aggregate demand, short-run aggregate supply, and long-run aggregate supply all meet, with output at potential.
When actual aggregate output is below potential output.
When actual aggregate output is above potential output.
The percentage difference between actual aggregate output and potential output.
Over the long run, output gaps close on their own as sticky nominal wages eventually adjust, returning output to potential.
The use of fiscal or monetary policy to soften the swings of the business cycle.
Policymakers cannot cure both problems at once: boosting aggregate demand eases the output slump but worsens inflation, while cutting demand fights inflation but deepens the slump.
Because of lags in recognizing problems and enacting responses, poorly timed stabilization policy can actually make the economy less stable.
Government transfer programs, such as Social Security and Medicare, that protect families against economic hardship.
Increasing government purchases or transfers, or cutting taxes, to shift the aggregate demand curve to the right.
Reducing government purchases or transfers, or raising taxes, to shift the aggregate demand curve to the left.
Government purchases affect aggregate demand directly, while changes in taxes and transfers affect it indirectly by altering households' disposable income.
A change in government purchases has a stronger effect on the economy than an equal-sized change in taxes or transfers, because part of a tax or transfer change is absorbed by saving.
Taxes that do not depend on income; unlike other taxes, they do not reduce the size of the multiplier.
Tax and transfer rules that automatically dampen business-cycle swings, such as taxes falling and jobless benefits rising during a recession.
Deliberate changes in taxes or spending decided by policymakers, as opposed to automatic responses built into the system.
The collapse of spending deepened the 1930s slump, while the surge of government spending during World War II helped pull the economy out, illustrating the multiplier in action.
The American Recovery and Reinvestment Act of 2009 used expansionary fiscal policy, boosting spending and cutting taxes, to counter the Great Recession.
Practice quiz
An economy has a Marginal Propensity to Consume (MPC) of $0.75$. The government decides to increase its purchases by $50 \text{ billion dollars}$. Simultaneously, it implements a lump-sum tax increase of $50 \text{ billion dollars}$. What is the net effect on the economy's aggregate demand in the short run, assuming no other changes?
- Aggregate demand increases by $50 \text{ billion dollars}$.
- Aggregate demand decreases by $50 \text{ billion dollars}$.
- Aggregate demand increases by $200 \text{ billion dollars}$.
- Aggregate demand remains unchanged.
Answer: Aggregate demand increases by $50 \text{ billion dollars}$.
An economy's aggregate consumption function is given by $C = 100 \text{ billion dollars} + 0.8 \times \text{DI}$, where $C$ is aggregate consumption and $DI$ is disposable income. If planned investment spending increases by $20 \text{ billion dollars}$ and there are no taxes or government spending, what is the total change in equilibrium real GDP?
- Real GDP increases by $100 \text{ billion dollars}$.
- Real GDP increases by $20 \text{ billion dollars}$.
- Real GDP increases by $120 \text{ billion dollars}$.
- Real GDP increases by $160 \text{ billion dollars}$.
Answer: Real GDP increases by $100 \text{ billion dollars}$.
An economy experiences a significant increase in the price of a crucial imported raw material. Describe the immediate short-run impact on the economy and the subsequent challenge for policymakers attempting to use stabilization policy.
- The price level falls and output rises; policymakers face a dilemma between fighting inflation and boosting output.
- The price level rises and output falls (stagflation); policymakers face a dilemma between fighting inflation and boosting output.
- Both the price level and output rise; policymakers can easily use expansionary policy to further boost output.
- Both the price level and output fall; policymakers can easily use contractionary policy to stabilize prices.
Answer: The price level rises and output falls (stagflation); policymakers face a dilemma between fighting inflation and boosting output.
An economy is currently operating with actual aggregate output below its potential output, indicating a recessionary gap. Assuming no government intervention, describe the long-run adjustment process that will return the economy to potential output.
- Nominal wages will rise, shifting the Short-Run Aggregate Supply (SRAS) curve to the left, increasing the price level and returning output to potential.
- Nominal wages will fall, shifting the Short-Run Aggregate Supply (SRAS) curve to the right, decreasing the price level and returning output to potential.
- Aggregate Demand (AD) will automatically shift to the right due to increased consumer confidence, closing the gap.
- The Long-Run Aggregate Supply (LRAS) curve will shift to the right, increasing potential output and closing the gap.
Answer: Nominal wages will fall, shifting the Short-Run Aggregate Supply (SRAS) curve to the right, decreasing the price level and returning output to potential.
Explain how an increase in the aggregate price level leads to a decrease in the quantity of aggregate output demanded, specifically by detailing the mechanisms of the wealth effect and the interest rate effect.
- A higher price level increases the purchasing power of money holdings (wealth effect) and lowers interest rates (interest rate effect), both reducing consumption and investment.
- A higher price level reduces the purchasing power of money holdings (wealth effect) and raises interest rates (interest rate effect), both reducing consumption and investment.
- A higher price level reduces the purchasing power of money holdings (wealth effect) and lowers interest rates (interest rate effect), leading to increased consumption and investment.
- A higher price level increases the purchasing power of money holdings (wealth effect) and raises interest rates (interest rate effect), leading to increased consumption and investment.
Answer: A higher price level reduces the purchasing power of money holdings (wealth effect) and raises interest rates (interest rate effect), both reducing consumption and investment.
A firm planned to invest $100 \text{ million dollars}$ in new equipment and $20 \text{ million dollars}$ in inventory. However, due to unexpectedly low sales, its actual inventory level increased by $30 \text{ million dollars}$ over the period. What was the firm's actual investment spending for the period?
- $130 \text{ million dollars}$
- $120 \text{ million dollars}$
- $150 \text{ million dollars}$
- $110 \text{ million dollars}$
Answer: $130 \text{ million dollars}$
During a recession, the government considers two options: a discretionary increase in government purchases of $100 \text{ billion dollars}$ or allowing automatic stabilizers to reduce tax revenue by $100 \text{ billion dollars}$. Assuming an MPC of $0.75$, which policy would have a larger initial impact on aggregate demand and why?
- The discretionary increase in government purchases, because its multiplier is $4$, leading to a $400 \text{ billion dollars}$ increase, compared to the tax reduction's multiplier of $3$, leading to a $300 \text{ billion dollars}$ increase.
- The reduction in tax revenue from automatic stabilizers, because its multiplier is $4$, leading to a $400 \text{ billion dollars}$ increase, compared to the government purchases' multiplier of $3$, leading to a $300 \text{ billion dollars}$ increase.
- Both policies would have the same impact, as they both involve a $100 \text{ billion dollars}$ change in spending or revenue.
- The discretionary increase in government purchases, because its multiplier is $3$, leading to a $300 \text{ billion dollars}$ increase, compared to the tax reduction's multiplier of $4$, leading to a $400 \text{ billion dollars}$ increase.
Answer: The discretionary increase in government purchases, because its multiplier is $4$, leading to a $400 \text{ billion dollars}$ increase, compared to the tax reduction's multiplier of $3$, leading to a $300 \text{ billion dollars}$ increase.
If the central bank decides to implement expansionary monetary policy, describe the sequence of events that leads to a rightward shift in the aggregate demand curve, focusing on the role of interest rates.
- The central bank increases the money supply, which raises interest rates, discouraging investment and consumption, and shifting AD to the left.
- The central bank decreases the money supply, which lowers interest rates, encouraging investment and consumption, and shifting AD to the right.
- The central bank increases the money supply, which lowers interest rates, encouraging investment and consumption, and shifting AD to the right.
- The central bank decreases the money supply, which raises interest rates, discouraging investment and consumption, and shifting AD to the left.
Answer: The central bank increases the money supply, which lowers interest rates, encouraging investment and consumption, and shifting AD to the right.
An economy has an initial Marginal Propensity to Consume (MPC) of $0.8$. The government wants to stimulate the economy by $200 \text{ billion dollars}$ through a tax cut. If the tax cut is a lump-sum reduction, what size tax cut is needed? If, instead, the tax cut is implemented as a reduction in the marginal tax rate, effectively increasing the MPC to $0.9$, what would be the new multiplier for government spending?
- Lump-sum tax cut: $50 \text{ billion dollars}$; New government spending multiplier: $10$.
- Lump-sum tax cut: $40 \text{ billion dollars}$; New government spending multiplier: $5$.
- Lump-sum tax cut: $200 \text{ billion dollars}$; New government spending multiplier: $10$.
- Lump-sum tax cut: $50 \text{ billion dollars}$; New government spending multiplier: $5$.
Answer: Lump-sum tax cut: $50 \text{ billion dollars}$; New government spending multiplier: $10$.
An economy is initially in long-run macroeconomic equilibrium. Suppose there is a sudden, significant increase in consumer confidence, leading to a positive demand shock. Describe the short-run effects on the aggregate price level and aggregate output, and then explain the long-run adjustment process assuming no government intervention.
- Short-run: Price level rises, output rises (inflationary gap). Long-run: Nominal wages fall, SRAS shifts right, price level falls, output returns to potential.
- Short-run: Price level falls, output falls (recessionary gap). Long-run: Nominal wages rise, SRAS shifts left, price level rises, output returns to potential.
- Short-run: Price level rises, output rises (inflationary gap). Long-run: Nominal wages rise, SRAS shifts left, price level rises further, output returns to potential.
- Short-run: Price level falls, output rises. Long-run: Nominal wages fall, SRAS shifts right, price level falls, output returns to potential.
Answer: Short-run: Price level rises, output rises (inflationary gap). Long-run: Nominal wages rise, SRAS shifts left, price level rises further, output returns to potential.
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